Engagement Radio: A Revealing Q&A with Alex Edmans on Engagement and Profitability

ESM: In this instalment of Engagement Radio, sponsored by C.A. Short and EGR International, we’re privileged to have Dr. Alex Edmans, Professor of Finance at London Business School. A graduate of Oxford, he has worked at Morgan Stanley in London in investment banking, has a PhD from MIT Sloan and recently did a Ted X talk at the London Business School based around social responsibility of companies.

Alex, there’s a lot of research, your own included, showing a connection between employee engagement and other types of engagement and the financial performance of a company. Do you think CEOs and investors are starting to understand that connection…that this is an important thing to consider?

Edmans: I do believe they are. For many years, people thought this is something that should be true on a qualitative level. People have had the sense that the more engaged employees are, the better the performance of the company should be, so companies say things such as, “People are our greatest asset. We invest in our employees,” but I think for many years this was just at the level of more nebulous, more intangible wisdom. I think what we’ve seen most recently – and this has been one of the goals of my research – is that we’re now putting numbers on this to show quantitatively how much employee engagement can affect your stock price performance and also address the question of causality. If you were just to show that companies with engaged employees do better, is it employee engagement that leads to better performance, or is it better performance that allows a company to invest in its employees? Given that we have now more research on the cause or quantitative effect of employee engagement, this I believe has started to convince the CEO’s and investors.

ESM: It sounds like we’re getting closer to where we need to be. Assuming that all of that is going on, how are you seeing this manifest itself in the marketplace and with companies?

Edmans: I think in subtle ways. Number one is I see investors being more interested in this, and I think it’s important to start with investors because CEOs and top management are agents of investors and they’re often accountable to investors. If investors don’t believe that employee engagement is important, if they’re just focused on evaluating management according to short-term profit, then the CEO will focus on short-term profit. I think it’s always important to start with investors, and with investors you do see a shift.

Let’s take my former firm, Morgan Stanley. The equity research department used to be divided into many different sub-units – there was the chemicals department which covered chemical companies, the financial institutions department which covered banks and insurance, etc. But a few years ago they launched a social responsibility team. We also see similar teams at UPS and other investors, and they really do understand that that social responsibility can be something which not only achieves your social goals but also affects financial returns.

There are some funds, like the Parnassus Endeavor Fund, which have a strategy to invest in companies with high employee well-being, and over the last 10 years since they were started they’ve beaten their benchmark by 4% per year. Given that we now see many more investors taking this seriously – even traditional investors who aren’t experts at socially responsible investing – they do seem to understand the intangibles like employee well-being do matter. This is why I think a lot of the initial movement has happened, and this is, I think, key to them getting managers on board.

ESM: Now, if a company actually believes and understands the research that you’ve done and the other research that’s out there, what are some of the very specific things a company could do to make sure that they’re falling in line with the social responsibility idea?

Edmans: I think number one is you need to start from the top. You need to start with the incentives of the chief executive. Just to give you a little summary of what my paper discusses, I find that companies with high employee engagement – which I measure using inclusion in the list of the hundred best companies to work for in America – they beat their peers by 2% to 3% per year over a 26-year period, so they significantly outperform. But here’s the catch: It often takes up to 4 to 5 years before the benefits of employee well-being show up in the stock price, so this is something which benefits the firm, but only in the long term.

The short-term effect of investing in your employees is probably going to be negative to profits, because it costs money to train your workers, to improve working conditions. This is why I think it starts from the top because, traditionally, CEOs are often concerned about meeting the quarterly earnings targets. But if we pay CEOs according to performance many years down the line, that will change their behavior. There’s a lot of focus at the moment on the level of the CEO’s pay – how much does the CEO get paid compared to the median employee? But I think what’s more important than the level of pay is the horizon of pay. Are they paid according to one-year performance or five-year performance? I think, really, an important place to start is to try to move towards the latter. Lengthen the performance horizon over which a CEO is evaluated and that, I think, is critical in terms of getting incentives to engage in investment into your employees.

ESM: Are you seeing any differences in philosophy based on the part of the world a company is in or how it operates culturally or politically? Is there any difference there that people should be aware of?

Edmans: Yes. My initial study that looked at just the United States, and why I focused on the United States to begin with, is because that data set – the best companies to work for – was available through 1984, so I had tons of data. Now, the Great Place to Work Institute in California has started to produce similar lists in other countries around the world – in fact, in 30 countries, because the list is so well respected. And out of those 30 countries, 14 of them have sufficiently developed capital markets for me to study the effect on stock price performance. I find that the results that I first charted in the U.S. do generally hold in other countries so, generally speaking, companies that treat their workers better do better.

Why I have to use the caveat “generally” is that it’s not always going to be the same in every country. In particular, in countries with rigid, less flexible labor markets like France and Germany, the benefits of employee well-being are lower, so why might that be? In those countries, there’s already a lot of employee protection because of unemployment benefits and protection against firing. Therefore, given that employees already have a high level of welfare, it’s not so important for a company to provide additional benefits to its workers. It’s particularly in countries like the U.K., U.S. and Canada, where labor markets are flexible, that the benefits of going above and beyond are most pertinent.

ESM: Obviously, the more flexibility you have in the way that you treat your workers, the more differentiation you can have as an organization, which should affect overall performance of the company. So where do you plan on focusing your research going forward? Do you have a future view of what you’re going to try to accomplish with this or where you think you might be researching deeper?

Edmans: I think I’d like to explore even more deeply the effect of long-term incentives. One of the striking findings of existing papers is that not only does employee well-being benefit the firm, but it takes so long to show up in the stock price. This led me to think that the incentive horizon of the CEO will have large effects on their behavior. In another paper, what I find is that in years in which the CEO has equity vesting, then the CEO is going to care about the stock price, because when the equity becomes salable they’re probably going to dump their shares in order to diversify. I find that in those years the CEO tends to cut research & development, cut advertising and cut investments, so it’s short-term behavior in order to boost up the short-term stock price.

In another paper on a similar theme, I find in the months in which CEOs have equity vesting, they tend to release a lot positive news to the market to lead to a short-term stock price boost and, of course, it leads to trading volume going up so they can cash out without affecting the price too much. They indeed cash out within a few days of news releases. This is more generally just trying to look at how we can reform compensation, so while a lot of the focus is on the level of pay and it’s politically alluring for a politician to say, “Let’s hold down CEO pay to a hundred times the median worker,” I think it’s the horizon of pay which will have the greater effect on how companies actually create value.

ESM: I’ll be interested to see how that works out. Alex, again, thank you so much for your time today. Hopefully we’ll hear more about your research in the future.

Edmans: Thank you very much. It was my pleasure.

Enterprise Engagement Resources

Profit from the new Book on Enterprise Engagement & ISO 10018, 5th Edition